Teaching Options

One basic question in preparing a course of study for individuals or groups is deciding which ideas can be taught vs. which can come only with experience.

Students can be helped to understand the greeks, what they represent, and how to make them correspond with the trader’s outlook for the market. In simple terms, all students come to understand that being long delta is likely to bring positive results when the market moves higher. However, there are enough exceptions that the student must be taught when delta (or any other greek) can be overwhelmed by other factors and fail to produce the anticipated profits.

One example occurs whenever news is pending. Option prices tend to be bid higher, so that the after-the-news-is-released collapse of implied volatility can result in the call (or put) owner suffering a loss, despite having correctly predicted in which direction the stock price would move. This is an important aspect of the learning process. However, it is reasonable to expect students to grasp the principle that predicting market direction is not sufficient to generate profits when using options.

Mindset: Moving from stock trading to options

Because getting market direction correct is not good enough, experienced traders often adopt ‘market neutral strategies.’ Instead of predicting the market will move higher or lower, the prediction (or wager) becomes: the market will not move too far in either direction. That is foreign to short-term traders

This represents a big change in mindset for the person who has experience trading stocks. Stock trading is all about direction – bullish or bearish; holding for the long term or short term, betting on daily price swings or 20-second price changes, etc.

Risk/reward ratio is another big change for the trader who is moving from stocks to options. Stock traders always want the trade to have more to gain than to lose. Option traders do not have to accept that limitation. For example, many traders make a living by selling a $5 call or put spread and collecting a $1 premium. The maximum loss is four times the maximum gain, yet this is viable for option traders.

Having the ability to get the options student to recognize that he/she has entered into a new realm is an important qualification for the options educator. It’s truly important to be certain that the student understands that options are different. As trite as that sounds, when that difference is not emphasized early in the education process, some students will be troubled with the idea of ‘risking so much’ to ‘earn so little.’

Risk Management

To help ease the transition of new options traders into our universe, the concept that managing risk (other than by using the stop-loss tool that is so valuable to stock traders) is the essential talent required for success. Timing may add to profits, but it is not as important as it is when trading non-option vehicles. Something as basic as this is mandatory in the training process.

But it involves more than that. I doubt there is an options educator on the planet who does not mention ‘risk management’ in one form or another. However, options are different. Options and option positions have risk that can be quantified (the greeks). When that’s possible, a whole world of risk management becomes available to the trader. We measure those risks and use ‘the greeks’ to describe them.

What’s the big deal? When trading options, knowing how much money is at risk if something specific (price change, IV change, time passes etc) happens – represents the opportunity to reduce and control any specific risk. If the stock trader fears that markets will become deadly dull and trade in a very narrow range, there is not much that can be done. However, the option trader can seek positions with positive theta and/or negative vega. Or, if the trader is a strict believer in owning positive gamma, then sitting on the sidelines becomes the appropriate strategy.

There is such a large advantage to knowing that the greeks can help plan strategies and measure risk, that failure to emphasize their importance makes the whole learning process far less valuable.

Philosophy

Taking a class when the course consists of:

Explanation of some strategies

Being told appropriate conditions for using each

The promise that you can read charts and predict market moves

is just not good enough. The mechanics of using options are important, but not sufficient. Learning the basics, understanding how to apply them, achieving proper (profitable) mindsets – those are important. Those are the ideas that the teacher must pass along to the beginning student. I wonder how many mentors who charge big bucks for an education understand these truths.